Economics and similar, for the sleep-deprived

A subtle change has been made to the comments links, so they no longer pop up. Does this in any way help with the problem about comments not appearing on permalinked posts, readers?

Update: seemingly not

Update: Oh yeah!

Friday, September 01, 2006

Why don't payday lenders own the entire world?

Lots of stories about the blogosphere about payday lenders working at military bases. It does really suck to be poor, and I would not want to disagree with the general tenor of the stories that this is a nasty state of affairs, but I have always disliked a particular way of presenting shock-horror numbers in coverage of the small-ticket lending sector and this is as good a hook to hang it on as any.

The story I've linked to refers to a "780% interest rate". Jeepers! That's dot com money! What happens to money if you are earning compound interest on it at 780 per cent?

I've just opened up a spreadsheet and found out. If you invest $1000 at 780% compound, then in five years it has grown to $52m, and in eight years it is $35trn, which is roughly the GDP of the entire world. After ten years you have $2.75 quadrillion, which is enough to buy the world five times over assuming a PER of 15.

Clearly this is not the case; payday lenders do not own the entire world, so we can assume that they are not getting 780%. So what's happening?

You might think it's something to do with loan defaults but it isn't, not really. It's an artifact of the mathematics of compounding. Say I lend you $30 until payday in ten days' time, and my administrative costs of doing this are $1.71 (ie, twenty minutes' time for a clerk on minimum wage) . If I'm going to cover my costs, then that's a 5.7% charge per ten day loan. To convert this to an annual percentage rate, take 1.057^(365/10)-1, which is 656%! What's at work here is that, if there is any element of fixed costs, then it is very inefficient indeed to borrow small amounts of money for short periods of time.

I don't think it makes sense, therefore, to think about payday loans in terms of APRs. Sure, it would be cheaper for the clients of payday lenders to borrow at credit card rates of 17.9% APR, but this is just saying that it would be cheaper for them not to be poor.

(I think that this is why "microfinance" was a silly idea too, btw, and note that almost everything carried out under that name today is just perfectly straightforward banking in the Third World. Lending to a farmer to buy a tractor is a fine thing to do, but it isn't microfinance).1 comments this item posted by the management 9/01/2006 04:53:00 AM